Short selling: what is it and how does it work?
July 23, 2021
6 minutes to read
What is short selling?
Short selling is a technique by which investors make a profit when a price drops. Short sellers borrow shares and then sell them. Later, they buy back the shares at a lower price (unless the price rises, of course) and return the shares to the lender. Their return is then the price difference between the shares they sold and the shares they bought back.
Short selling is actually a strange phenomenon: nothing in the real economy resembles it. If you buy a share, you can think of it like a product you buy in the supermarket. Just like the share, a bar of chocolate or a pineapple seems a good investment for you. But if you find something in the supermarket you really don't like – strawberry yoghurt, for example – you probably wouldn't be tempted to trample on all those pots. And you wouldn't try to convince all the other customers to stop buying strawberry yoghurt, either.
On the stock market, however, you can do better than just ignoring things you don't like. You can actively track down overvalued shares or companies you believe are in poor shape. If you go short on a share like this, you can make a profit if and when the price of the share falls. Short selling isn't just available for shares, but for bonds and trackers, too.
Is short selling (un)ethical?
Short selling is the subject of much debate. On the one hand, short sellers are sometimes abhorred as vultures that want companies to fail for their own benefit. On the other hand, short sellers believe that they're doing a useful job.
Many shares that have been pushed way high by small investors in recent months have had heavy short selling in common. These include GameStop, AMC Entertainment and other so-called Reddit shares. Some of the investors who pushed these shares sky high see themselves as being at war with the institutional and 'arrogant short sellers of Wall Street'.
With GameStop, among other things, a crazy group of small investors saw an opportunity to make money by setting a trap for the short-selling hedge funds. Reddit investors bought GameStop shares on a massive scale. And when the price of a share rises sharply, short sellers are helpless and have to capitulate. The shares that they've borrowed and sold must be bought back at a fixed point. This then pushes prices up even further. As a result, a group of small investors saw their profits multiply, while a few short sellers suffered billions in losses.
The story often sounds different from the short sellers' camp. They don't just see the financial markets as a garden where you must allow healthy plants to continue growing. They believe that plants that don't bear fruit or have wilted away can be pruned, or even pulled up. Short sellers often see themselves as critics and sceptics. They don't own the shares (and don't want to), but they do give a signal that a share may be overvalued or that all isn't rosy in the garden.
For example, the fall of Enron, Lehman Brothers and Wirecard was partly triggered each time by short sellers who discovered that there was something rotten in their accounts. From this point of view, short sellers help to put things right and uncover malpractice. If you invest in a share that's being heavily shorted, you should therefore do some extra research.
What are the risks of short selling?
Short selling is mainly the preserve of investors who are able and willing to take very high risks. The potential profit from short selling is limited: the value of a share can only go down to 0. But, in theory, the potential loss can be infinite if shares continue to rise and rise. Short sellers can't simply sit back and wait for the rest of the world to agree with them.
Any investor who took a short position in GameStop on 25 June 2020 at $4.46 could earn a maximum of $4.46 per share, less financing costs (to borrow a share, you pay a fee or interest to the lender). If the short seller maintained their position until 24 June 2021, by then they were in the red by over $200 for each share they shorted, plus the costs. If you catch a following wind, short sells can deliver a real windfall. But if it doesn't work out, the consequences can be catastrophic.
When can short selling be useful for an 'ordinary investor'?
You can also short a share or share index for very different reasons, such as protecting your investments against drops in price. Suppose you're expecting a market correction. Instead of selling your entire portfolio, you can create a buffer to cushion some of the impact. This can be done by investing in products that will benefit from a fall in the market. If there is a correction, the value of your portfolio will fall, but the value of the product with which you took out a short position will rise. The reverse also applies, of course: if the markets rise, your portfolio will rise, but your short position will be worth less.
A buffer can be created by buying a tracker that shorts a share index, for example. Some trackers also work with leverage. In the case of a 'double short', the tracker will generally rise by 2% in the event of a 1% fall. There are also many derivatives available to hedge a portfolio, such as put options, put warrants and turbo shorts. However, these products require in-depth knowledge and are only suitable for investors who want to take a very high risk, as you can lose your entire investment.